When bond managers stopped playing defence Before the global aggregate benchmarks existed, managers were measured against global government bond indices. To outperform, they added corporate credit to their portfolios, says Matt McCrum, director of investments with Omega Global Investors. This spurred the creation of an aggregate benchmark that would make managers more accountable for their returns. But in time, additional credit markets, such as hybrids and securitised mortgages, were also absorbed, increasing the amount of yield in the benchmark. This goaded managers to take more risk. They added yield to their portfolios, and larger managers that were not nimble enough to access particular corporate credit segments were compelled to increase the yield in their portfolios, whenever and wherever they could, McCrum says. “You’ve got 14,000 [bond] issues, 22 countries, MBS [mortgage-backed securities], ABS [asset-backed securities] – in a way it’s too complicated for one manager,” he says.
During the decade in which the global aggregate benchmark expanded, many institutional investors were preoccupied with the “glamour” markets of infrastructure and private equity, he says, so “the door was open for managers to make freewheeling decisions on the weights between government, corporate and even domestic versus international bonds”. But when the credit crunch hit, investors learned how the drive for yield had undermined their fixedincome defences. “It was a particularly hard way for investors to learn the fixedincome paradox: while the upside is limited, the downside can be 100 per cent.” According to Omega, previous credit market slumps saw managers underperform by 0.2 to 0.3 per cent. But in the financial crisis, their returns fell between 10 and 20 per cent. Managers which added yield by investing in emerging market debt, credit derivatives and subprime mortgages generally incurred the worst losses. “Whereas they had previously sacked managers for underperforming in fixed interest by .03 per cent, during the crisis many fixed interest managers underperformed by more than 1 per cent and investors frankly did not know what to do.”
But it wasn’t only speculative managers that suffered. McCrum says many large managers missed the globalisation of credit markets and assessed credit through “increasingly irrelevant” country or regional frameworks. “The lesson from this – again learned the hard way – is that it is very hard to get a European bank credit analyst to talk to a US bank credit analyst and then incorporate their combined views into a meaningful and integrated portfolio construction recommendation.” Making money from Greece As they reconsider their fixed income defences, institutions face many risks, chief among them inflation and sovereign defaults. MLC’s short-duration Horizon funds mitigate inflation risk by investing in bonds that mature in the next one or two years. In its riskier, longer-duration portfolios, it uses inflation-linked bonds to guard against rising interest rates, while buying other longer-dated instruments.